The False Theory behind Tax Reform, Part 1: Revenue Neutrality

by Wyoming Liberty Group Staff

We have repeatedly warned against raising taxes in Wyoming. I have also warned that any attempt to "reform" our tax system without prior structural reforms to spending will result in tax hikes. Since the political conversation still trends in the direction of such reforms, it is time to revisit the last of these two warnings.

The reason for this is that Governor Mark Gordon has given the ENDOW group a tax-reform assignment. According to the Casper Star Tribune the governor wants to

take a "realistic look" at the state's energy dependent tax system and better understand the implications of the Wyoming's seemingly endless cycles of boom and bust.

Before we continue, let me pause and stress that the cyclical pattern he is talking about is not the Wyoming economy per se. It is the cyclical peaks and troughs in state tax revenue. In other words, Gordon is not out to end the inherent, almost natural-law like shifts in economic activity – all he wants to do is shield government from the consequences of those shifts.

This means, in practice, that he is out to adjust the private sector to government, not the other way around.

Anyway. Back to the Tribune:

On Friday [June 21], the leaders of Wyoming's economic development group, Endow, got an early glimpse at how Gordon plans to accomplish that review. Led by University of Wyoming's Steve Farkas – the assistant dean for its business school's MBA program – the Energy Futures Modeling Group will spend the next several months developing an understanding of the state's energy-dominated revenue streams. The group's work will include simulating future prospects for the state's primary revenue sources and modeling the impacts of ebbs and flows in prices on different areas of the state.

There is nothing wrong per se with this kind of study. The problem lies instead in the purpose behind the state's demand for it. The Tribune again:

The study – which is focused primarily on the state's energy-dominated tax structure – is meant to serve as a foundation to future talks about the state's tax structure, and what opportunities or risks any changes would create. "These are very early discussions," Farkas said in his presentation to the Endow Council. "Fundamentally, we've created a framework for these discussions to move forward. But it's very important for this group to have input from you all, and would like to solicit that input as we think about innovative ways to position the state's key energy assets in a way to generate new sources of revenue."

So far, Governor Gordon has shown a healthy skepticism toward raising or creating new taxes. Therefore, we can assume that his ambition with the ENDOW tax-reform study is to find a way to get the same tax revenue without the peaks and troughs that follow the business cycle in the private sector. In other words, Gordon wants a revenue-neutral tax reform. This is a reform that shifts at least some of the tax burden from current taxpayers or taxes to other taxpayers or taxes.

Theoretically, this is a good idea for which there is a fair amount of support in microeconomic literature. The problems amass when we try to apply that theory to the real world. To work, it

1. Cannot raise the total tax burden,
2. Must bring in at least the same amount of revenue, and
3. Cannot affect economic activity.

The last point is the reason why revenue-neutral tax reform is close to impossible.

In order to not produce less revenue, a tax reform relies on the idea that a cut in one tax will increase disposable income for consumers, or revenue for businesses, by as much as it will decline because another tax was increased. For example – and this is what the Revenue Committee discussed in the lead-up to the 2019 legislative session – a cut in taxes on goods by one half of one percent would leave us consumers with X dollars more in our pocket. Then a new sales tax on services, and one on food, would take away that same X amount of dollars.

Our bottom line would have to be the same.

Why? Because if we lost disposable income we would reduce our overall spending. If we do, there is a macroeconomic multiplier effect that, spreading through the economy, has negative repercussions elsewhere. Those repercussions in turn cause a further decline in tax revenue.

Microeconomists who suggest that revenue neutrality is possible, typically disregard the macroeconomic effects of their reforms. The reason is not that they are ignorant (although to be fair, throughout the years I have encountered a nice crop of ignorami among practicing economists…) but that the purpose behind a revenue-neutral reform is not to leave consumers unaffected.

It is to leave tax revenue unaffected. If, in the balance, consumers take a hit, then that is collateral damage.

We should note that the revenue committee that worked out a sales-tax reform back in 2018 did so under the auspices of leaving consumers unaffected. There were, however, never any calculations to prove this point, and I suspect – frankly – that those calculations never even existed. But I'd be happy to concede on this point if anyone has such calculations to show.

The same point, in principle, applies to the kind of tax reform that Governor Gordon appears to have in mind. Ostensibly, he wants to shift energy taxation away from minerals, toward some unspecified source that would produce enough revenue to leave the state unaffected.

Let us assume that this new, yet-to-be-taxed energy source is wind. A revenue-neutral reform involving a production tax on wind (the closest proxy to a severance tax) would have to assume that it is possible to introduce an entirely new tax on this form of energy production without so much negative effects on the entrepreneurial desire to produce that same energy, that it reduces the bottom line for the state government.

Is that possible? Econometricians will tell us they can do it. My experience with prior tax reforms is that those calculations never materialize as predicted. The reforms typically depress the economic activity where a new tax was introduced to such a degree that government lost revenue.

The reason why revenue-neutral tax reforms fail appears to be, namely, that they ignore the very business cycle they want to neutralize against. We will return to this very point in Part 2.